What a week for learning in Washington D.C. This was the first year that academic superstars Lawrence Summers, Ben Bernanke, and Christine Romer have gotten together to offer their new lecture course on “The Economics of the Great Recession of 2009”.
I enrolled in the course, which was taught at the Brookings Institution and the Council on Foreign Relations, in order to understand how these eminent academics actually think about the great large challenges ahead. Of course, it was actually three different lectures, but together it really did add up to as good a class as you could get on this subject.. It was clearly intended not only to educate but also to demonstrate that there is an overall plan to the President’s economic plan.
In that, it was obviously aimed at the larger classroom called the United States.
And there was some pretty direct signaling to those overseas — not only to Chinese premier Wen Jiabao, who on Friday had described himself was “a little bit worried” about U.S. economic policy and the security of China’s investment in U.S. government securities, but also to all the other G-20 leaders who will be getting together to hash out global economic strategy in London on April 2.
All three professors are more than highly-qualified to each the course. If you check the syllabus, you will find that both Federal Reserve Chairman Bernanke (Princeton) and Council of Economics Chairman Romer (University of California) have devoted much of their academic careers to seeking to understand the Great Depression, which used to be a long time ago. Now it turns out that the Depression did not happen so long ago after all. It is probably useful that the major research interest of these two key decisionmakers happens to be the Depression. The academic work of National Economic Council head Summers (Harvard) includes studies of numerous financial crises. He also comes equipped with the first-hand experience of helping to battle the financial crises of the 1990s.
Where to start? Of course, by explaining how a garden variety recession had turned into the Great Recession. But that is not all that easy. “The fundamental causes,” said Professor Bernanke with some understatement, “remain in dispute.” And each of the professors came at it from somewhat different perspectives.
Professor Bernanke was pretty sure that the causes were “the global imbalances in trade and capital flows that began in the latter half of the 1990s” — “a chronic lack of savings” in the United States and an “extraordinary increase in savings” in “many emerging market nations.” Basically, he was saying, the United States had morphed into a sort of supergiant “emerging market” country – resembling the emerging market countries that could not handle “large inflows of savings from abroad” in the 1990s and fell into crisis.
THE PROPENSITY TO BUBBLES
Professor Summers rooted the crisis in the psychology of market, the propensity to bubbles, and the innate character of human beings – “excessive complacency and excessive optimism”. With a certain irony, he added that the “central paradox of the financial crisis’ is that ‘what we need today is more optimism and more confidence.”
Summers did go back to Economics 101 (or in his case, at Harvard, Econ 10). “One of the most important lessons in any introductory economics course is that markets are self-stabilizing…When the economy slows, interest rates fall. When interest rates fall, more people take advantage of credit, the economy speeds up, and the market equilibrates. This is much of what Adam Smith had in mind when he talked about the ‘invisible hand’.”
“However,” he continued, “it was a central insight of Keynes’ General Theory that two or three times each century, the self-equilibrating properties of markets break down…(and) are overwhelmed by vicious cycles. And the right economic metaphor becomes an avalanche rather than thermostat…. Declining asset prices lead to margin calls and de-leveraging, which leads to further declines in prices.”
“An abundance of greed and an absence of fear on Wall Street led some to make purchases – not based on the real value of assets, but on the faith that there would be another who would pay for more for those assets. At the same time, the government turned a blind eye to these practices and their potential consequences for the economy as a whole. This is how a bubble is born. And in these moments, greed begets greed. The bubble grows.
“Eventually, however, this process stops – and reverses. Prices fall. People sell. Instead of an expectation of new buyers, there is an expectation of new sellers. Greed gives way to fear. And this fear begets fear.”
Most recessions since World War II, Summers said, had resulted from “the Federal Reserve’s efforts to control rising inflation.” But, he continued, “an alternative source of recession comes from the spontaneous correction of financial excesses:.. Unfortunately, our current situation reflects this latter, rarer kind of recession.”
“This is the paradox at the heart of the financial crisis. In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying. Today, however, our problem is exactly the opposite.”
Clearly, Summers thinks have gone much too far in terms of abject fear. At the beginning of last week, he said, the Dow Jones Industrial average, “adjusting for inflation to the standard Consumer Price Index, was at the same level as it was in 1966. Some, he said, might regard this “as the sale of the century.” For policymakers, “it suggests the magnitude of the gains from restoring sustained economic growth.”
In Professor Romer’s textbook, the “fundamental cause” of the current recession is “the decline in asset prices and the failure or near failure of financial institutions.” The link between the two is “modern innovations such as derivatives” which “led to a direct relationship between asset prices and severe stress in financial institutions.” And that dried up credit, which helped bring the economy to a standstill.
The biggest of her “Lessons from the Great Depression for 2009” was about getting fiscal stimulus right. The New Deal, she said, applied much less fiscal stimulus than generally thought, and that lack of sufficient stimulus was a very big mistake. A second big mistake was reining in too soon such fiscal stimulus as was applied, leading to the less-well-remembered Recession of 1938, which was only cured by the stimulus spending of World War II. As Professor Romer put it, “One crucial lesson from the 1930s is that small fiscal expansions have only small effects.”
Clearly, the follow-on lesson is the rationale for a Big Fiscal Stimulus in 2009. To reinforce that point, she cited another lesson: “Beware of cutting back on stimulus too soon.”
"THIS IS JUST A WHOLE OTHER ANIMAL"
During the lecture, one of the students asked Professor Romer why it had been so difficult to see this recession coming – “why the great surprise?”
“One of the things I thought I knew in the postwar period is business cycles were caused by the Fed tightening and then that caused a recession, and then the Fed loosened and it was over, she replied. ” Not this time. “This is just a whole other animal.”
The second reason, she added, was “the international ramifications.” Through the summer, many people thought that while “the U.S. went down,” the rest of the world would not. That turned out to be wrong….We didn’t realize how interconnected our financial institutions were, but I think that’s probably the main source of the surprise.” In other words, that once much-vaunted decoupling between the United States and the rest of the world fed what proved to be a dangerous complacency.
Professor Bernanke focused in on fixing regulation so that the Great Recession – or worse – does not happen again. It was clear that he is more than preoccupied with what he called “the Too Big to Fail problem” (read AIG, Citigroup). Too-big-to-fail “reduces market discipline and encourages excessive risk-taking.” In fact, there is a perverse incentive “for firms to grow in order to be perceived as too big to fail” – meaning that they can take more risks because they know they will be bailed out.! The answers, he said, were much more intensive regulation that envelops the entire enterprise and eliminates any “gaps” that allow “risk-taking to migrate from more-regulated to less-regulated sectors”.
One could almost read into Professor Bernanke’s words a novel solution to the “Too Big to Fail problem,” which is to make regulation so intrusive — and indeed so irritating — as to discourage firms from reaching for that august status of too big to fail!
He also put firmly on the table the idea of what he called “macroprudential” regulation, which would be looking not at individual firms but at “systemic risks” – such as – just to take an example that happens to come to mind — the hyper-growth of subprime mortgages. Here, too, one might read into his words a substantial shift in Fed policy: Perhaps regulators should, after all, do something about bubbles before they get out of hand.
One of the most intriguing parts of Bernanke’s lecture was his suggestion that the much-debated mark-to-market accounting might actually need some tinkering. The reason? Its undesirable trait of encouraging “procyclical tendencies” – which is central bankese for helping to drive values up higher than warranted and then slamming them down farther than appropriate.
He became a little more explicit. Mark-to-market, he said, is “one of the things that tends at times to increase the severity of ups and downs in the financial system and in the economy.” He said is definitely against “any suspension of mark to market…. But, in periods like this, when some markets don’t’ even exist or are highly illiquid… the numbers that come out can be misleading.” Or, he added, “not very informative, at best.”
“Guidance,” he said, is definitely needed to “financial institutions and to the investors about what are reasonable ways to address the valuation of assets that are being traded – if traded at all, — in highly illiquid, fire-sale type markets.”
Professor Summers made clear – perhaps in a nod to that worry that bothers Chinese Premier Wen, along with others – that he does not like deficits. “When I left Washington eight years ago, people were debating what to do when there was no more federal debt,” he dryly observed. “ That is hardly our problem today.”
But there is no choice, according to his economics textbook , to a very big stimulus today. For, as he said, “the crucial problem is a broad shortage of demand” and investment. For the longer term, he said, picking up on Professor Bernanke’s core argument, the United States has to move away “from foreign debt-financed growth.”
Professor Summers did so go far as to talk boldly about “the next economic expansion.” He didn’t put any date on it, but he, with great conviction, did tell all students in the “Economics of the Great Recession” course that “there is one enduring lesson in the history of financial crises: they all end.”
One can be sure that the three professors hope that this recession will end soon enough that this course does not need to be offered next year. Or, if it is, only as a small seminar.
Daniel Yergin, CNBC’s Global Energy Expert, is chairman of Cambridge Energy Research Associates an IHS company and author of The Prize: the Epic Quest for Oil, Money, and Power, now in a new edition.